RMCF

I posted my RMCF article on Seeking Alpha and got a great question about my valuation of Hersheys and Mondelez. I adjusted RMCF’s forward P/E for taxes at 13x while seemingly ignoring Hershey and Mondelez’s potential tax benefits:

The chocolate business can still generate $4 million per annum but with President Trump’s tax cuts (15% tax rate assumption), it goes up 25% to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.

The actual TTM P/E’s for Hershey’s (HSY) and Mondelez (MDLZ) are 30x and 40x. The multiples above for HSY and MDLZ are Pro-forma or ‘adjusted’ earnings, which are inflated, whereas their GAAP earnings are significantly lower. So the multiples above are more than already inclusive of a tax discount even though MDLZ doesn’t deserve it — the real valuation discount is much higher than 25% when one compares apples to apples. Investors and sell-side analysts have come to expect ‘adjusted’ earnings from those two. HSY and RMCF have similar historical tax rates (about 35%), and MDLZ’s tax rate is much lower so the discount shouldn’t change much in a post-tax adjustment scenario. Hence why I was comfortable comparing the adjusted earnings to RMCF’s tax-adjusted forward net income. The scale and brand advantage that MDLZ and HSY have over RMCF indicates that it should certainly trade lower — the question is how much lower? Hence why I have a price target just 20-25% higher than my purchase price.

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I recently added Rocky Mountain Chocolate Factory (RMCF), my cost basis is $10.99 @10% of the portfolio. The company manufactures and sells premium chocolate and has a long history of profitability. The company makes money by wholesaling chocolate to its franchisees and collecting revenue-based royalties. In 2013, the RMCF took a controlling interest in Yogurt maker, U-Swirl (SWRL). SWRL made some debt-financed acquisitions and defaulted and so RMCF took over SWRL and effectively guaranteed its debt. The takeover proved to be expensive as SWRL is still losing money, and in dissent, outspoken shareholders sold off the stock while management maintained its confidence in SWRL.

Risk

As consumers, specifically millennials, become more health conscious, confectionery will likely stagnate. I don’t see the stagnation as much of a big deal because the pace of a decline, if so, will be negligible and people will still eat chocolates in 100 years. If anything, the industry is likely to be stable over the long run and even with a zero growth, RMCF still presents an attractive entry point.

Management made a mistake but has realized that the assumptions for the yogurt business were a bit optimistic, and as of Q3’s earnings call in January, the CEO acknowledged that. Given that franchisees control the majority of these stores, it only makes sense that they exit the business if it remains unprofitable which is evident in the chart below.

RMCF’s current and historical tax rate is about 36%, and the company will significantly benefit from President Trump’s expected tax cuts (more so than the general markets).

50% of products sold at the stores are produced on premises, 45% of products sold are manufactured in the company’s Colorado factory, with the remaining 5% being purchased from third-party suppliers. In essence, the company relatively immune from President Trump’s border tax.

Source: RMCF SEC Filings

The chocolate business can still generate $4 million per annum, and with President Trump’s tax cuts (15% tax rate assumption), it goes up 25%, to $5 million. The company’s dividend yield at today’s price is 4.4% dividend today and could move up to 5% assuming the dividend yield increases along with the expected income increase from the President’s proposed tax plans. Absent of a tax overhaul, it trades at 16x earnings today. With the tax overhaul, however, we’d be paying 13x next year’s income for a very stable business whereas its competitors command valuations that exceed 20x and are not growing. Hershey’s and Mondelez trade at 23x and 21x this year’s earnings and 21x and 19x next year’s earnings, respectively. Tootsie Roll trades at 19x. RMCF has the highest tax rate among its competitors and still trades below competition without an overhaul so I don’t see why RMCF shouldn’t trade around the $13-$14 range.